What Can Derail the Carry Trade?

Global Fixed Income Bulletin

What Can Derail the Carry Trade?

December 2017

In this Goldilocks environment of robust growth, modest inflation and loose financial conditions, it's difficult to see why fixed income investors should not continue to be overweight nongovernment bonds to help enhance yield. Strong 2017 returns do mean future returns are likely to be lower than this year, but the environment remains highly supportive of the continued outperformance of riskier fixed income. The greatest risk to this scenario is that central banks surprise the market and tighten monetary policy significantly more than what is currently discounted in financial markets. This situation remains a low-probability event in our minds. The bottom line is that while markets have run a long way, and future returns are likely to be more modest, the current environment is likely to continue, i.e., the 2017 strategy should continue to work in 2018.

DEVELOPED MARKET (DM) RATE/FOREIGN CURRENCY (FX): Progress on tax reform and the rising odds of a December rate hike led U.S. yields to rise throughout the month and the yield curve to flatten. Reversing the trend for the last two months, the dollar declined versus major currencies as risk-on sentiments resumed.

We expect the U.S. Federal Reserve (Fed) to hike rates in December. A more assertive Fed, better growth and increasing odds for tax reform would likely push long-term yields modestly higher. In addition, we see some scope for inflation to rise in 2018 following the strength in growth this year. As a result we are also positive on U.S. TIPs. In terms of currencies, after a short bout of risk-off and dollar strength, risk appetite seems to be returning. We therefore think moving toward a dollar underweight makes sense again.

We remain optimistic about the prospects for EM fixed income as we move toward 2018, as country fundamentals and the macroeconomic environment remain supportive. We are also cognizant of potential geopolitical risks. However, we anticipate such events will be transitory and idiosyncratic to specific countries, rather than systemic. De-globalization risks may intensify as North American Free Trade Agreement (NAFTA) renegotiation talks stretch into 2018, but we remain optimistic about the final outcome.

CREDIT: Global Credit indices were little changed in November and remained within a few basis points of post-crisis lows. Investors experienced more dispersion and volatility across ratings and sectors than has been seen for some time. The resurgence of idiosyncratic risk is yet another sign that markets are continuing to normalize.

While there are certainly both positive and negative forces acting on the market, we continue to see opportunity for spreads to tighten a modest amount over the near and medium terms. Credit spreads are near post-crisis lows but remain wider than previous cycles, while improving economic growth should help ensure stable fundamentals. We do believe the majority of beta-driven compression is past us at this point in the cycle, so we find ourselves focusing much more on alpha-generating opportunities arising from renewed idiosyncratic volatility.

SECURITIZED: Agency mortgage-backed securities (MBS) underperformed slightly in November, while credit-sensitive securitized assets continued to outperform. Nonagency MBS spreads were essentially unchanged in November, while cash flow and credit performance continued to improve.

As 2017 comes to a close, we expect continued outperformance by securitized assets. While we do not expect further spread tightening, the fundamental conditions in the securitized markets remain very positive, and the cash flow-based carry of securitized assets should continue to generate compelling returns. The biggest risk we see in the near term is a potential shock in interest rates. If interest rates were to rise more than 100 basis points, these higher rates could create some problems for affordability and refinance-ability.

The views and opinions are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. The views expressed do not reflect the opinions of all investment personnel at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.

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